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Alternative Investments and UBIT: Knowing is Half the Battle

Part one of a two-part series on tax consequences of alternative investments



Income diversificationIn the aftermath of the Great Recession, charitable organizations emerged as increasingly sophisticated savvy investors. At a time when donations dwindled and endowments were shrinking, the not-for-profit sector sets its sights on income diversification, including alternative investment vehicles such as partnerships, private equity funds, real estate investment trusts and hedge funds. No longer just the bailiwick of elite institutions, alternative investments are continuing to grow in popularity. However, the tax compliance issues associated with these investments can sneak up on unsuspecting not-for-profits, many of whom are unaccustomed to paying federal income taxes due to their preferential, tax-exempt status.

When it comes to understanding unrelated business income taxes (UBIT), knowing is half the battle. I find that it is helpful to explain to clients the history behind the legislation that brought us to where we are today. The tax rules regarding UBIT are a result of legislation passed by Congress in 1950 to ostensibly level the playing field between commercial entities and tax-exempt not-for-profit organizations that would otherwise have a built-in market advantage when conducting similar businesses due to their preferential tax status. Organizations that engage in unrelated activities pay a tax on the income from those activities at corporate rates (or at trust rates for exempt organizations that are created as trusts) unless a specific exemption or exception applies.

Though many people are aware of the types of activities that raise traditional UBIT considerations, it’s important to understand that the applicable regulations also apply to certain indirect types of trade or business income, including the returns generated by some alternative investments.

The provisions are extensive, but generally all types of ordinary income are subject to the tax unless a special exclusion or exception exists. IRC Sec. 512 contains several important exclusions, including most types of passive income, such as interest, dividends, rents, royalties and gains or losses from the sale, exchange or disposition of property.

It is important to note that there is a very significant exception to the exception — such passive income can be taxable if derived from debt-financed property, defined as property held to produce income that is acquired using financing. For example, if a tax-exempt organization purchases corporate securities, commercial or rental real estate with borrowed funds, all or part of the dividends or rental income from the property may be subject to UBIT. This distinction applies whether the organization uses debt financing directly or indirectly through a partnership.

Another important exception to the rule involves investment in the increasingly popular S corporation structure. Any exempt organization that is a shareholder of an S corporation will always recognize tax on unrelated business taxable income (UBTI) or on its ownership of S corporation stock.  Therefore, a charity that owns S corporation stock must take into account its share of the S corporation's income, deductions or losses in figuring UBTI, regardless of the actual source or nature of the income, deductions and losses. 

For example, the organization's share of the S corporation's interest and dividend income will be taxable, even though interest and dividends are normally excluded from UBTI as mentioned above. The organization must also take into account its gain or loss on the sale or other disposition of the S corporation stock itself, in figuring UBTI.

While it’s imperative to understand the implications and exposures of these types of investments, it is equally important to know where to get this information. Typically, unrelated business income can be found by reviewing investments. As these are most often structured as partnerships, this would be done through providing a Schedule K-1 from the partnerships Form 1065 to the tax exempt organization.

Any partnership carrying on a trade or business must provide its partners the information necessary to enable them to compute its distributable share of partnership income or loss from such trade or business in accordance with the UBTI rules (Sec. 6031(d)). This is done through IRS Schedule K-1. One might think this would make life pretty easy; after all the partnership is required to provide the information. All we have to do it pop it in a form. Unfortunately, this is very often not the case.  The IRS instructions are somewhat vague, and that has led to divergence of practice and poses special challenges for exempt organizations and their business advisors.

To learn more about UBIT, check out this webcast on Unrelated Business Income Tax: Tips, Tricks, and Traps to Minimize Tax Liability, taking place October 24. The AICPA’s Not-for-Profit Section’s resource library contains additional information for its members.

Israel Tannenbaum, CPA, Senior Manager, WeiserMazars LLP. Israel has over a decade of experience serving not-for-profit clients in a range of subsectors. He specializes in delivering insightful, comprehensive consulting and compliance tax services to clients in the not-for-profit sector as well as Fortune 100 companies and pension trusts. He is one of the many speakers presenting at this year’s AICPA National Not-for-Profit Industry Conference, coming up June 27-29.

Income diversification image courtesy of Shutterstock

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